What Happens in Vega…

by Tyler Craig | April 13, 2012 6:30 am

After a peek at delta[1] and probabilities as well as an exposé of theta’s thievery[2], we now turn to a somewhat lesser known, yet equally important Greek – vega. Though not an official letter of the Greek alphabet, vega measures an option’s sensitivity to a one-point change in implied volatility. Since changes in implied volatility can have drastic effects on an option’s value, keeping an eye on your position’s sensitivity to this variable can prevent you from being blindsided.

Similar to the other Greeks, vega’s reading can be either positive or negative. When buying options, traders acquire positive vega effectively making them long volatility. When selling options, traders acquire negative vega, effectively making them short volatility.

Suppose after analyzing implied volatility and deciding the current level of 20% was too low, you purchased a long volatility strategy (such as a straddle) by simultaneously buying an at-the-money call and put option.

Let’s say the straddle’s vega was +40, meaning it should rise in value by $40 for every one-point increase in implied vol. If over the next few days implied vol rises from 20% to 25%, how much would your straddle increase in value? Given the five-point rise in volatility, your straddle should increase by $200 (5 x 40). On the other hand, if implied vol dropped five points from 20% to 15%, your straddle should fall by $200.

Interestingly, vega is also influenced by the time remaining to expiration; longer -term options will typically possess a higher vega and shorter-term options will have a lower vega. This fact should actually be quite intuitive. If implied vol doubles, should it have greater effect on an option that expires tomorrow or one that expires in six months? The obvious answer is the six-month option as it will have much more time to be affected by larger price moves in the stock.

Like theta, vega is also highest for at-the-money options since they possess the most extrinsic value. As an option moves deeper in-the-money or further out-of-the-money, its vega will drop.

Equipped with a proper understanding of vega, traders should be able to calculate exactly how much money is on the line each and every day with respect to changes in implied vol.